Will Real Estate Investment Trusts Crash If the Fed Raises Interest Rates?

U.S. Federal Reserve officials will meet today (Wednesday) and tomorrow to discuss whether or not to raise interest rates. The meeting could mark the first Fed rate hike in almost 10 years.

One type of stock affected by interest rates is real estate investment trusts (REITs). These are companies that own or finance income-producing real estate assets. They're often associated with shopping malls, offices, hotels, and apartment buildings.

REITs are high-yield investments that pass 90% of their profits to shareholders.

Many investors believe real estate investment trusts suffer if the Fed hikes interest rates. They assume REITs underperform when the cost of money increases due to its critical role in real estate investing.

But that's not always the case...

These Real Estate Investment Trusts Perform Well During Rate Hikes

According to Money Morning Chief Investment Strategist Keith Fitz-Gerald, a Fed interest rate hike will not kill all REIT returns.

"Contrary to what a lot of people believe, REITs have historically done well when the cost of money is increasing," said Fitz-Gerald earlier this year. "REITs are not the investing zombies many investors think when it comes to rising rates."

Fitz-Gerald looked at how REITs performed during periods of rising interest rates, as measured by the 10-year U.S. Treasury note. REITs have historically seen gains when the 10-year Treasury bond yield has risen.

This chart shows how much real estate investment trusts have returned when the yield has risen more than 1%...

The Fed

From 1994 to 2013, there were nine separate periods when the U.S. Treasury yield was higher than 1%. During six of those nine periods, REITs provided positive returns.

Not all REITs perform the same way, though. Some do get hurt when interest rates are high...

Equity-based REITs have the best returns when interest rates rise. They invest directly in income-producing properties like malls and office buildings rather than personal homes. Equity REITs are less sensitive to rate hikes because they usually see plenty of cash flow and appreciation to render any price drop due to higher rates irrelevant.

On the other hand, mortgage REITs - ones that invest in personal homes - can get hammered from rate hikes. That's because rising rates pressure the housing market and make buyers more afraid to borrow money to purchase a home.

But is this time different for REITs' performance?

"I get that question a lot - usually more as it relates to traditional dividends and income than real estate," said Fitz-Gerald. "But either way, it really doesn't matter much. The principle is the same - there is a strong correlation between high total returns and the management approach taken to dividend policy."

One REIT Fitz-Gerald likes is Omega Healthcare Investors Inc. (NYSE: OHI). That's because it offers double the profit potential by tapping into two of his Unstoppable Trends - Medicine and Demographics.

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Omega primarily invests in hospital and healthcare facilities. It specifically leases long-term contracts to operators of nursing and assisted-living facilities.

The company also targets a growing senior citizen demographic. The U.S. Census Bureau reported that the number of Americans aged 85 and older makes up about 2% of the population as of 2013. That group is expected to comprise 5% of the U.S. population in 35 years, making OHI's customer base around 21 million people.

Omega has increased its dividend by 8% year over year and currently boasts a yield of 6.5%. Yahoo! Finance gives OHI stock a one-year price target of $40.31 - a 21.3% increase from its previous close of $33.22.

The Bottom Line: With the FOMC meeting this week, investors are wondering how a rate hike will affect the performance of real estate investment trusts. Since equity REITs rely on consistent streams of revenue from property tenants, they are able to withstand the pressure better than mortgage REITs. Omega is a healthy equity REIT to invest in because it offers a strong dividend yield and ties into a growing healthcare market and demographic.

More questions about real estate investment trusts? Ask us on Twitter at @AlexMcGuire92 and @moneymorning.

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